Mike Maloney wonders if it is time to "Man the Life Boats"

And a great interview with Schiff and Walker on Lou Dobbs...

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So where are we heading?

So where are we heading?

As faithful readers know, we often profile US bank failures on Friday. This stems from our Prime Minister who early on in 2009 said, "there won't be an economic recovery until the U.S. financial system is repaired."

US Bank Failures for the year stand at 95 (will we break 100 today?).

But that pales to the list of over 400 banks who are teetering on the edge of insolvency. So dire is the looming problem that the cash-depleted Federal Deposit Insurance Corporation has hatched a plan to require banks to prepay three years of quarterly fees. The little accounting trick will generate $45 billion in cash for the FDIC, an amount it normally would've had to wait years to get its hands on.

It's an odd move because the FDIC could simply borrow money from the Treasury Department. This is well within the rules of the FDIC. The agency has a credit line with the Treasury to tap as much as $500 billion in emergency capital through the end of next year. But the FDIC is worried that if the agency, which has always been privately funded through bank assessments, borrowed money from the Treasury, it would look like a new bank bailout, eroding the sliver of confidence the public has regained in the USA's banking system in the past few months.

Instead the FDIC has arranged this 'dues pre-payment' option. But won't this hurt bank earnings or deplete lending?

It seems the FDIC is going to take advantage of an accounting quirk that allows companies to spend money on something but not actually tell their shareholders about the cost until the asset is gone. As Time magazine notes, "for you and me, it would be like shoplifting at the supermarket and then dropping off cash every time you decided to eat something. A can of beans might not cost you anything for years. The rule is supposed to match the revenue generated by the stuff a company buys with its costs, and it is called depreciation. But to anyone other than a CPA, it looks like a sleight of hand."

So US bank troubles continue and the FDIC is scrambling to prepare for an avalanche of additional failures.

Meanwhile the trend of strategic mortgage defaults in the United States gallops along, compounding the woes of the banking industry.

It all adds up to what we having been suggesting for months... that the underlying economy is still very weak and that the current stock market rally is nothing more than a bear market trap.

This means the North American economy is probably facing a continuing period of deflation over the short term. Even so, many leading deflationists think that – after a period of deflation – we will certainly get inflation.

The million dollar question is: when?

It's a crucial question. When it comes to investing, being too early is being wrong.

Someone who is positioned for inflation decades too early will get creamed. Likewise, someone who is betting on deflation for 20 years will get hurt if inflation kicks in next month.

One reader suggested in an email we might be even be facing a period of mixed-flation; inflation in some asset classes and deflation in others.

Given that speculators drove up the price of oil last year, it is possible that – especially in a stagnant economy – speculators could drive up the prices of some asset classes and drive others down.

We'll explore the issue more next week.

Let's wind up the week with Bank of Canada Governor Mark Carney's latest warning that there is "no guarantee rates will stay low" .

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Or is it the Looming Era of Deflation?

There has been an interesting trend developing lately in the bond market.

Some of the world's biggest bond funds have been buying longer maturity US Treasuries in recent weeks. With significant flattening on the long end of the yield curve, analysts believe this reflects the re- emergence of deflationary fears. Basically the treasury market is increasingly skeptical of the reflation effort taking hold in the North American economy.

If they are correct the United States will be at the center of an ongoing deflationary de-levering as opposed to an accelerating, inflationary growth period.

Those that hold to this opinion believe that deflation is being fuelled by continuing overcapacity, shrinking credit, reduced corporate spending and falling consumer demand.

Backing this up is data showing consumer prices falling at their fastest clip ever last month in Japan (no mean feat considering Japan has been fighting a losing war against deflation for much of the past two decades). Meanwhile Germany, Europe's biggest economy, has now suffered through four consecutive months of sliding prices, and the rest of the region that uses the euro is not faring much better.

Should deflation take hold, the result would inevitably be years of dismal economic performance, staggering unemployment, deeply pessimistic consumers and businesses that cease spending and focus on surviving.

“We are certainly in a deflationary state,” said David Rosenberg, chief economist and strategist with Gluskin Sheff and Associates in Toronto. “Of that, there's no doubt.”

“I think people still have no clue as to just how weak the economy is,” Mr. Rosenberg said.

The ultimate fear is that if you remove the massive stimulus being administered by governments, most economies are at a virtual standstill.

The end result? A decade of stagnation for the North American economy.

Perhaps that's why Bank of Canada Governor Mark Carney, in a speech to the Greater Victoria Chamber of Commerce on Monday, called on the private sector to step up and get the economic recovery going.

"The global recovery is in its earliest stages, and is almost entirely driven by public policy," Carney said. He then warned that governments and central banks have done all they can after putting in place "war-time spending on a peaceful calamity".

"It's now up to the private sector to start spending," Carney said. "Otherwise, the fragile recovery will weaken as government stimulus ends. Consumer and business spending will need to drive economic growth in Canada."

Oh my... it's back to scolding the 'bad consumer' again.

So are we set to trigger inflationary times as the end of the recession moves trillions of stimulus dollars into circulation and combines with the pressures of servicing massive amounts of government debt?

Or will the economy sputter with faltering demand, dropping prices, rising unemployment and plateauing interest rates because financially-stressed consumers are unable (or unwilling) to go back to their hyper-consumer ways?

It's hard to say. But one thing is for certain: deflation is far more destructive than inflation.

Just this past Monday, the City of Vancouver confirmed it will eliminate 60 full-time jobs in order to deal with a $61 million budget shortfall this year. The revenue woes are being blamed on the weak economy and federal and provincial budget cuts.

And that's only the tip of the iceberg.

If deflation takes hold, the stock market will suffer a massive correction, tons more businesses will fail and unemployment will skyrocket beyond what are already substantial highs.

And what will that mean for real estate?

Hundreds of thousands of newly unemployed will be unable to pay mortgages. Wave after wave of boomers will be retiring each year and desperately trying to sell their homes because that's where their retirement funds are stored. And the younger generation is unable to step up and fill the void because they lack both the numbers and the income from a floundering economy.

Back in February and March we made a number of posts about the possibility of a depressionary slide.

And while we lean towards the inflationary outlook (75% vs 25%), the reality is either scenario is still possible.

There is only one thing for certain. Neither inflation or deflation bodes well for real estate.

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Prechter Vs Schiff (Deflation vs Inflation)

Those of you who visit this site regularly know that we have harped ad nausem on the belief that the economic collapse that took place last year was a deep, economic earthquake... the repercussions of which we are still coming to grips with.

Will the ecomonic collapse and massive fiscal stimulus trigger high inflation and interest rates? Or is the economy in a spiral leading to further deflation and low interest rates for years to come?

In the past this blog has profiled the viewpoints of Bob Prechter and Peter Schiff. One is regarded as the leading deflationist speaker, the other considered the leading inflationist pundit.

Over the last two weeks two different interviews were conducted by Jim Puplava; one with Prechter and one with Schiff. The interviews gave these two a chance to clearly present their views and supporting evidence.

If you are so inclined, click on the links above to listen to the full interviews.

In summary, Prechter's key point is that there is an ocean of unpayable debt which must result in a deflationary collapse and depression (huge unemployment, big hit on the standard of living, etc.).

Schiff agrees that there is an ocean of unpayable debt, but disagrees on what the outcome will be. He expects a dollar collapse and an inflationary depression (huge unemployment, big hit on the standard of living, etc.).

Interestingly there is a lot more agreement between the “deflationists” and the “inflationists” than you would think.

Prechter claims that the creditors will not allow the Federal Reserve to “print its way out of the debt” and that the key evidence for this is that the Fed has tried really hard to keep from doing anything to really, really tick off its creditors.

Schiff claims that the Federal Reserve will keep “printing debt” until the creditors refuse to buy any more and that is when the printing goes into high-gear and there is a currency collapse (dollar plummets) and the inflationary depression really kicks in.

Personally we lean more towards Schiff's take on things.

Schiff claims that the government and Federal Reserve have been printing money and causing inflation non-stop for decades. That's how we ended up in the massive bubble conditions that currently exist (or, in the case of the US, are in the process of bursting). More importantly there's nothing to stop the American government and the Federal Reserve from continuing this process. Schiff cites very powerful reasons for the government to continue including:

• Allowing the government to spend money without having to raise taxes.
• Inflation allows the government to tax assets (when sold) which have not gone up in value (for example when you sell a house), and
• Inflation automatically drives tax payers into higher brackets increasing their tax burden.

Prechter, on the other hand, claims a major shift has taken place in the last year with credit contracting and a major change attitude to avoid debt.

Prechter claims the amount of monetization so far is puny compared to shrinkage in the amount of credit outstanding and that even if all of the bad debt was replaced with 100 dollar bills it would not create inflation because it would just replace what was formally in place.

Schiff's outlook seems to be more based on data and natural reasoning about cause and effect and is more in sync with the experience of the last few decades. Prechter, on the other hand, has been more accurate on what has happened the last 18 months or so. To date Schiff has been wrong in the short-term about the dollar and inflation.

So what can we conclude?

Neither seems to understand why USA creditors (China, Japan, etc) keep buying USA debt and neither has a grip on what will trigger these nations to step back.

Yet this is the key to the current economic situation. Everyone wants to know when and/or if it will change suddenly.

Regrettably there is no clear winner of this controversy right now, although we favour Schiff's outlook.

We are nearing two crucial points that will occur towards the end of this year. They could tell us which way things are going to go.

The first is that the Federal Reserve funds for monetizing debt is scheduled to run out in October. The Federal Reserve will then either have to:

• Stop buying treasuries and Fannie Mae/Freddie Mac debt. This may very well cause interest rates to launch into the stratosphere triggering another major contraction in the markets. This will result in the dollar rising in a flight to safety. If this happens Prechter is proved right.
• Announce another round of monetization and have the creditors belly ache but keep on buying treasuries. If this happens the jury is still out.
• The Federal Reserve will announce another round of moneitization and have the creditors refuse to keep buying treasuries resulting in a dollar collapse. If this happens Schiff is proved right short term.
• Secretly continue monetization (with perhaps a delayed reaction resulting in a dollar collapse).

The second crucial point will come when year over year commodity prices start rising in Q4 (unless there is another crash). The Consumer Price Index (CPI) should stop falling and start rising. These events will probably keep the U.S. Dollar on its downward collapse.

Any significant resumption of CPI rise will prove Schiff right short term. Prechter's outlook doesn't really allow for this, although he gives himself test of requiring all prices to rise to new highs.

At this point we will have a clear picture of whether Inflation or Deflation lies on the horizon.

Of course, both may be wrong and the ocean of debt may be supportable. In that case the North American economy will just muddle through indefinitely, with GDP growth and super low interest rates allowing the USA to work its way out of debt (or at least sustain the debt).

Personally we don't see that happening.

The key to the whole situation is the reaction of USA creditors to the continued piling up of USA debt.

How how long will they just grin and bear it?

Ultimately that is the bottom line.

Personally we can't see any outcome other than that the USA will continue to pile up and monetize debt. Eventually this will lead to a major dollar collapse when times get really, really bad.

How to plan and prepare depends on your assessment of the situation.

We truly do live in interesting times.

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